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Since May 2011, this blog has been exclusively focused on Singapore. All my other reflections are now posted in "Notes from Noosphere" (see link under "Miscellany" on the right margin).

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Saturday, March 3, 2012

Donald Low, via Chen Show Mao, on Public Economics

Economics 101. Many of you wrote to me with your views on the subject of government spending (from which I learned a great deal), including the following [from Donald Low's FC].

****** Chen Show Mao's postscript ************

Recently, many of you wrote to me about issues raised by parliamentary speeches on social programs. One of you summarized in a particularly incisive way the different economic issues raised.

The sender told recipients of his note to feel free to share its contents without individual attribution. He told me that he preferred not to be cited by politicians.

So I shared it with you on my FB page with a preface: "Many of you wrote to me with your views on the subject of government spending (from which I learned a great deal), including the following."

******************************************

First, spending on the poor and disadvantaged is no less of a self-funding investment than any other form of government spending. Whether it is “welfare” for economically vulnerable citizens or spending on growth-promoting “economic” projects, each such spending is a cost in the period it is incurred. From an economics viewpoint, there is no conceptual difference between public spending in healthcare, social safety nets or eldercare projects on the one hand, and spending on security, infrastructure or other economic projects on the other. There seems to be perception among many policymakers that the former is a form of consumption that should be minimized or managed more carefully, while the latter is a form of investment that we do not need to scrutinize as much. This is simply bad economics.

Should only monetary or financial returns be considered in determining whether a social spending proposal merits government support? Some of us support the government’s measures to spend more on the elderly, the disabled, the poor and other needy Singaporeans, but lament that these inevitably incur costs. But nothing the government does is “self-funding” in the sense that the project’s financial returns to the government are sufficient to pay for its original government outlay, only in the sense that the project’s overall benefits to society will be worth its costs. It is precisely because there are public and merit goods which the market is not well-placed to provide that we need governments to finance their provision – via either taxation or government borrowing. Whether these are roads and highways, defence, the police and emergency services, the MRT system, schools and hospitals, none are self-funding in the sense that they are “bankable” or viable without public funding. If they were, we would expect the market to provide them. Social spending is thus no more and no less “self-funding” than other types of government expenditure.

The right question to ask is not whether a particular project incurs costs (they all do), or how much it costs (it is the balance of costs and benefits that matter), or even where the revenue for it has to come from (since all government monies are fungible and we always have to prioritize how these monies should be spent). Instead, the right question to ask is this: given all the things that government is asked to finance, which yields the largest social returns? The central fiscal question is always “how should we allocate and prioritize given our scarce resources?”

This brings me to the second point: the importance of having an expansive definition of social returns. Economists often take pains to emphasize that the costs and benefits government uses to determine the merit (or lack thereof) of a particular project should include not just direct or financial costs/benefits, but also indirect and intangible ones. They should also include avoided costs. For instance, if increased spending in early childhood education leads to cost savings as a result of less spending subsequently in learning support programs in primary schools (for children who have not benefited from pre-school education) or less teenage delinquency, these cost savings should be counted as returns. These returns should then be weighed against the costs of the program. Or if an extra $1 million of spending on preventive healthcare for older persons leads to savings of $3 million in the form of avoided costs in acute hospitals, the government would be well advised to spend more on preventive healthcare. Of course, we should also make sure we use the proper discount rate as people value future returns less than immediate returns.

The third point is that there are no economically ideal rates for taxes or government borrowing. Take borrowing. If a road improvement project costing $10 million leads to cost savings of $20 million (say as a result of fewer road accidents and fatalities, or lower costs of road repairs subsequently), that’s an investment return of 100%. Even if government has to borrow to finance that spending, it should do so.

Or take income taxes. There is nothing in economics which says that higher or lower income taxes are necessarily bad for the economy. On the one hand, higher marginal tax rates may reduce people’s willingness to work via the substitution effect. By making leisure less costly, higher taxes encourage people to substitute leisure for work. On the other hand, by reducing people’s take-home income, higher taxes may induce greater work effort as they try to maintain their previous standard of living. This is known as the income effect. Which of the two effects is stronger is entirely an empirical question; there is no reason why the substitution effect would necessarily outweigh the income effect.

Fourth, we should ask if we are indeed at an optimal Budget position currently so that any new social spending measure would require new revenues. To simply assume so may be flawed on at least two levels. The first is a status quo bias, which is that all past and current expenditure items pass the cost-benefit test outline above and that any new projects has to be financed by new revenues. This is quite clearly wrong. Even if all our current spending passes the cost-benefit test, are we so sure that their net benefits are greater than that for new (social) projects? Given how much our operating context has changed – a fast ageing population, wage stagnation, rising inequality – surely the presumption is that we would have to shift some of our fiscal resources to emerging needs and new areas of priority, rather than to assume that the current areas should be similarly funded as before and new areas would have to be financed from new revenues. To insist so would be to lock ourselves in past, and most likely inappropriate, patterns of public spending.

The second reason why such an assumption may be flawed is that it does not take into account our fiscal position of structural surpluses. Given that we have been running considerable structural surpluses for the last 20 years, it becomes even more important for the government to show how continuing to invest our savings abroad yields superior returns than investing in our own people. That we run such large and persistent surpluses also implies that the government believes that it has exhausted all public projects where the social returns exceed their financial costs. I find this hard to believe.

On a related note, the question of whether any new social spending proposals have to be financed by new or higher taxes cannot be properly answered until we have better information on the government’s reserves position and its expected future contributions to financing the government’s spending. While we probably do not need to know the exact amount of reserves for this purpose, government should inform the public of whether it is utilizing the full 50% of net investment returns (NIR) that it is entitled to, as well as what it expects future NIR contributions to be. Only with such information can citizens have an informed debate about whether increasing social spending will entail higher GST or other taxes. Without such information, government’s assertions on how increased spending in healthcare for instance will require higher GST are no better than mine, or anybody’s for that matter.